More than half of Europe’s investment community, both on the buy-and sellside, is worried about new trading rules which could reduce liquidity in the fixed-income market and raise the cost of issuing debt.

The concerns, highlighted in a survey published today by the Association for Financial Markets in Europe, come as European policymakers put the finishing touches to the rules introduced by the Markets in Financial Instruments Directive.

Afme’s Investor Survey of Fixed Income Liquidity found that 56% of respondents believe the Mifid II rules will have an adverse effect on the European fixed-income market by causing a decline in trading volumes, reducing transaction sizes, increasing the cost of trading or putting a stop on the market altogether.

The new rules aim to impose greater transparency on a host of products traded in the over-the-counter markets.

Although they have been softened since they were first unveiled, the latest wording of the rules remains a cause of consternation to banks and investors.

Of particular concern is a proposal that would oblige a marketmaker to provide a quote to buy or sell any non-equity illiquid instrument upon a client’s request, regardless of whether the dealer holds the necessary inventory or wishes to engage in the trade.

Dealers presently have the discretion to refuse to quote, or to provide a provisional quote that they can subsequently alter. The Mifid II proposal would make it harder for dealers to manage their risk, say critics.

Christian Krohn, managing director at Afme, said: “Some ambiguity remains, including with respect to elements of the pre-trade transparency rules which is a concern and which was reflected in the survey. The majority of respondents feel that the rules will negatively impact trading activity in fixed income, leading to a decline in liquidity.”

Christophe Roupie, global head of trading and securities financing at Axa Investment Managers, said: “These types of obligations are easier to provide in liquid markets, but being forced to provide quotes in less liquid bonds will lead to the bid-offer spread widening out and will, therefore, create inconsistency and volatility. Forcing marketmakers to provide quotes will also distort the price-discovery mechanism.”

He added that existing electronic bond trading order books – such as NYSE Euronext's BondMatch – are able to offer firm prices to multiple users in both liquid and less liquid instruments without obliging marketmakers to provide quotes. "Whatever is ultimately decided, care has to be taken to look at what is already available and ensure the liquidity of the bond markets is not further impaired", according to Roupie.

Lars Horngren, chief economist at the Swedish National Debt Office, warned that any resulting reduction in liquidity would hit primary debt issuance. He said: “The secondary market is essential for primary market behaviour. If investors are concerned that they won’t be able to sell bonds, they will be reluctant to buy them in the first instance from government debt offices. Our concern is that a decline in liquidity will ultimately raise funding costs.”

The survey also found that 63% of investors believed the market needs both electronic trading and phone-based trading to maintain optimal liquidity. Phone-based trading is also under threat by the new rules, which will promote its replacement with electronic platforms.

Krohn said: "The other point that respondents emphasised was the importance of choice in terms of how they execute. Many want to continue to use the phone for trading in some instruments."

Afme surveyed 100 institutions across the fixed-income investment community in November.

*A shorter version of this article ran in Financial News print edition